As equity rally continues firing on all cylinders, remember Sir John Templeton’s legendary warning: bull markets eventually ‘die on euphoria’

The two questions on every investor’s lips right now are: is the rally in line with underlying fundamentals and does the bull market in stocks have further to run?

PUBLISHED : Thursday, 11 January, 2018, 10:24am
UPDATED : Thursday, 11 January, 2018, 10:40pm

Stock market euphoria could not come at a worse time. As recently as last summer, the nine-year rally in global stocks was still being dubbed “the most-hated bull market” in history.

At some point towards the end of last year, the persistent scepticism which equity investors – particularly in the US – had harboured since the global financial crisis suddenly gave way to a more optimistic mood.

As the second trading week of 2018 comes to a close, sentiment is now positively euphoric.

This is because the equity rally is firing on all cylinders.

Global stocks, as measured by the FTSE-All World Index, a leading gauge of stock markets in developed and developing economies, shot up 22 per cent last year, their sharpest increase since 2009. The index, moreover, has experienced 14 consecutive months of gains, the longest streak on record. Several major markets, including Japan, Germany and Hong Kong, posted double digit returns in 2017.

Global stocks, as measured by the FTSE-All World Index, a leading gauge of stock markets in developed and developing economies, shot up 22 per cent last year, their sharpest increase since 2009

Yet it is in the buoyant US equity market where the shift from investor scepticism to ebullience has been the most pronounced.

Last week, the benchmark S&P 500 index, which rose nearly 20 per cent last year and has hit a succession of fresh highs, equalled the 1965 record for the second-longest run of trading days without a 5 per cent decline.

According to Bloomberg, the “14-day Relative Strength Index”, a technical indicator which tracks the size and speed of movements in stock prices, shows that the S&P 500 has been in overbought territory since the end of last year.

Price targets for the index, which rose a further 2.6 per cent last week, for the end of this year are already close to being met. In a much-publicised note last week, Jeremy Grantham, the founder of asset manager GMO and a renowned spotter of asset bubbles, predicted the equity rally has further to run, with US stocks “showing signs of entering the blow-up or melt-up phase of this very long bull market.”

The two questions on every investor’s lips right now are: is the rally in line with underlying fundamentals and does the bull market in stocks have further to run?

The fact that the most important driver of equities is the global economy’s synchronised growth spurt provides a degree of reassurance and is stirring animal spirits among traders and investors.

On Tuesday, the World Bank raised its forecast for global growth this year to 3.1 per cent, a tad higher than last year’s rate which was already the fastest since 2011. The development lender expects the global upswing to continue for at least the next couple of years, underpinned by increased investment and manufacturing activity.

Make no mistake, the stock market rally is a global phenomenon.

In the US, corporate earnings are expected to post double-digit growth this year for the first time since 2011, according to Factset, a data provider, buoyed by the sweeping tax reform package – which includes a dramatic cut in the corporate tax rate to 20 per cent – passed by Congress and signed into law by US president Donald Trump last month. The tax cuts, moreover, are not fully priced in to prices and earnings expectations, providing scope for further gains in equities.

This is the good news.

The bad news is that US stocks are significantly overvalued according to any popular valuation measure. The cyclically adjusted price-to-earnings ratio, or CAPE, suggests that US equities are now even more expensive than on the eve of the Wall Street Crash in 1929.

Just as worryingly, the nine-year-long Bull Run is partly, if not mostly, attributable to the ultra-loose monetary policies of central banks which have kept interest rates at historically low levels, underpinning high valuations.

Monetary stimulus has also turbocharged the 30-year-long bull market in fixed-income, making bonds even more expensive than stocks and fuelling demand for equities whose fortunes hinge critically on the outlook for debt markets. And therein lies the rub.

The sudden burst of optimism in equity markets is occurring just when bond markets are coming under strain. On Wednesday, the yield on benchmark US Treasuries rose to nearly 2.6 per cent, its highest level since mid-March, partly because of a report by Bloomberg that China is mulling reducing its holdings of US debt. Bill Gross, one of the world’s most prominent bond investors, has declared the beginning of a bear market in bonds.

While it is still unclear whether global debt markets are headed for a major rout, the exuberance in equity markets is ill-timed, to say the least.

Then again, it was the legendary investor, Sir John Templeton, who said that bull markets eventually “die on euphoria”.

Equity investors should take note.

Nicholas Spiro is a partner at Lauressa Advisory

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